United States: Estate Planning Update - July 2014

PLANNING FOR INCOME TAX BASIS "STEP-UP"

We continue to believe that passing property in trust for both a
surviving spouse and descendants offers the most benefit to your
family, because of estate tax savings and creditor protection
opportunities. However, a limitation of trusts is that trust
property is ordinarily not eligible for a "step-up" in
basis at a beneficiary's death. Property owned outright, on the
other hand, does get a "step-up" in basis at death, which
eliminates capital gains tax on any gains to that point. In the
current tax environment of lower estate and gift tax rates coupled
with higher income tax rates, this would seem to present an
"either/or" choice - take advantage of the trust
structure or give up the opportunity for capital gains tax relief
afforded by the basis step-up rules.

By taking creative advantage of well-established tax principles, we
have developed an innovative solution that avoids this
"either/or" choice. Our solution is to include a new
provision in trust agreements called the "contingent general
power of appointment," or CGP. The CGP causes trust property
to be included in a beneficiary's taxable estate at death in
order to qualify for a step-up in basis, as long as that will not
cause any increase in estate tax. The result - trust property with
previously unrealized capital gains can be sold with no capital
gains tax liability. The CGP is tailored to cause inclusion of the
least amount of trust property that will afford the most basis
step-up.

For example, assume a $1,000,000 trust for a child and his
descendants. By the time of the child's death, say in 30 years,
the trust assets have appreciated to $2,000,000. To keep the
example simple, assume the child dies with $1,000,000 of his own
assets as a resident of Florida (one of the many states without a
state estate tax). If properly planned, the trust will escape
estate taxation at the child's death. However, capital gains
tax would ordinarily be due on any sale of trust assets. If all
trust assets are sold after the child's death, the gain would
be $1,000,000 and the capital gains tax about $200,000. With the
CGP, however, the entire trust will be included in the child's
estate without causing any estate tax, since the combined value of
the child's $1,000,000 estate and the trust's $2,000,000
value is below the federal estate tax exemption. The included
property will receive a "step-up" in basis to the value
at the child's date of death and thus escape tax on the
$1,000,000 of capital gains.

We are now incorporating the CGP in new estate planning documents.
Please contact us if you would like to discuss the advantages of
including the CGP in your existing documents.

NEW YORK TAX LAW CHANGES

On March 31, 2014, New York state enacted several significant
changes to its laws concerning estate, gift and fiduciary income
taxes. The following summarizes some of the key changes:

Estate Tax Exemption Increased. The New York
estate tax exemption amount has been increased. This means that
more New York estates will be exempt from estate tax, but because
the tax rates themselves are largely unchanged, estates larger than
the applicable exemption will not see a reduction in the tax due.
For estates of decedents dying on or after April 1, 2014, the
exemption has been increased to $2,062,500. The exemption will
increase in roughly $1,000,000 increments effective April 1 of each
of the next three years, until, effective for decedents dying on or
after January 1, 2019, the New York exemption will be the same as
the federal exemption. The phase-in of the estate tax is steep,
causing New York estates that are only slightly larger than the
applicable exemption amount to incur a disproportionate amount of
estate tax. Clients subject to New York estate tax may wish to add
a provision to their estate planning documents that will include a
gift to charity if that gift will reduce the amount of estate tax
due by an amount greater than the gift itself. For example, in 2018
when the New York exemption is $5,250,000, a taxable estate of
$5,500,000 would owe $443,150 in estate tax, but by making a
charitable gift of $250,000, there would be no estate tax due, and
the amount passing to the intended beneficiaries would increase by
$193,150.

Some Gifts Included in Taxable Estate.
Although New York does not have a gift tax, lifetime taxable gifts
made by New York residents between April 1, 2014, and December 31,
2018, and within three years of death will be included in the
decedent's taxable estate for purposes of calculating the New
York estate tax. Accordingly, New York residents contemplating
taxable gifts (that is, gifts not covered by the annual exclusion
and not otherwise exempt from federal gift tax) should consult with
counsel before making any additional gifts before January 1, 2019.
Whether and how this will apply to gifts of non-New York property
remains to be seen.

Incomplete Gift Non-Grantor Trusts. So-called
incomplete gift non-grantor trusts ("ING trusts") had
been promoted as a way to avoid New York income tax on property
without making a taxable gift of that property. That preferred
treatment is no longer available. Starting with the January 1,
2014, tax year, New York will treat income earned by ING trusts as
"grantor" trusts, meaning that the income earned by the
trust will be taxed on the donor's individual return. An ING
trust liquidated prior to June 1, 2014, is exempt from this tax
treatment. Please let us know if you have an ING trust and would
like to discuss your options going forward.

Throwback Tax on Distributions to New York Residents
From New York Resident Trusts. Previously, New York
resident trusts with New York resident beneficiaries were exempt
from New York income tax so long as they did not have New York
resident trustees, New York source income, or New York real or
personal property (so-called exempt trusts), which meant that
accumulated (i.e., undistributed) income escaped New York taxation.
The new "throwback" tax will now impose a tax on
distributions made to a New York resident of previously
accumulated, undistributed income. Although the new law is
effective as of January 1, 2014, distributions made before June 1,
2014, are excluded.

DISCLOSURE OF FOREIGN ACCOUNTS AND ASSETS

U.S. persons are allowed to maintain financial accounts anywhere
in the world, but they must pay tax on all income and also file
special reports alerting the IRS to the existence of the accounts.
In recent years the IRS has put great pressure on foreign
institutions to disclose the names of U.S. clients. The IRS has
also created an Offshore Voluntary Disclosure Program
("OVDP") to allow U.S. persons with undisclosed accounts
to regularize their situations. (It is not an amnesty, since it
calls for significant penalties.) An alternative set of Streamlined
Filing Compliance Procedures ("Streamlined") was more
recently introduced for less egregious fact patterns.

On June 18, the IRS introduced significant changes to both OVDP and
Streamlined. These changes increase the amount of information
required for OVDP and alter the penalties payable under OVDP in
certain cases. The changes also broaden the availability of
Streamlined and extend it for the first time to U.S.-resident
taxpayers. These changes result from concerns that the penalties
within OVDP were too expensive for certain taxpayers whose failures
to disclose offshore accounts or assets were due to non-willful
conduct. Now, such taxpayers can proceed under Streamlined and
regularize their prior payment and reporting deficiencies while
avoiding the large OVDP penalty. At the same time, taxpayers whose
failures were not due to non-willful conduct may have their
penalties substantially increased if they do not come forward
promptly.

New Streamlined Program. Taxpayers whose prior
payment or reporting deficiencies were due to non-willful conduct
may now disclose previously unreported foreign assets through
Streamlined, whether or not they are U.S. residents. Non-willful
conduct means conduct due to negligence, inadvertence, mistake or a
good faith misunderstanding of the law. All taxpayers within
Streamlined will have to file three years of original or amended
tax returns and six years of original or amended Reports of Foreign
Bank and Financial Accounts ("FBARs"). Taxpayers will
have to pay any back tax for three years, plus interest. In
addition, U.S.-resident taxpayers will have to pay a miscellaneous
penalty of 5 percent of the value of all previously unreported
accounts and assets, in the year within the prior three tax years
that those assets had the highest value in the aggregate.
Non-U.S.-resident taxpayers will not be subject to this
miscellaneous penalty. No other penalties will be assessed against
either U.S.-resident or non-U.S.-resident taxpayers. Finally, all
taxpayers will be required to certify, under penalty of perjury,
that their conduct was non-willful and to provide a brief
description of the circumstances of the prior nondisclosures.

New OVDP. The basic structure of OVDP remains
unchanged; however, more information now must be provided, and the
timeline for paying the OVDP penalty is accelerated. To request
"preclearance" to apply for OVDP, taxpayers must now
provide identifying information on all banks or other financial
institutions where undisclosed accounts were maintained, in
addition to identifying themselves. Moreover, the narrative
"OVDP Letter and Attachment" now requires more detailed
information. In addition, whereas the miscellaneous 27.5 percent
"OVDP Penalty" previously became due upon the closing of
the OVDP case, that penalty is now due with the submission of the
taxpayers' amended tax returns and payment of back taxes,
applicable penalties and interest. (The OVDP Penalty equals 27.5
percent of the value of all previously unreported accounts and
assets, in the year within the prior eight tax years that those
assets had the highest value in the aggregate.) The taxpayer will
still have to file amended tax returns and FBARs for the previous
eight tax years, pay all tax, accuracy, failure-to-file, and
failure-to-pay penalties, as applicable, interest, and the OVDP
Penalty. Finally, the OVDP Penalty is increased to 50 percent if
any bank or other entity managing the taxpayer's funds or
accounts has been publicly disclosed as under investigation,
cooperating with U.S. authorities or the subject of a U.S.
court-approved summons. Taxpayers who submit a preclearance request
or the OVDP Letter and Attachment before August 4, 2014, will not
pay the increased OVDP Penalty of 50 percent, even if there has
been such a public disclosure.

"Transitional Period." Taxpayers who
are already participating in OVDP and whose prior non-disclosures
resulted from non-willful conduct may request that the IRS reduce
their 27.5 percent OVDP Penalty to the 5 percent Streamlined
penalty (or eliminate their OVDP Penalty entirely if the taxpayer
resides outside the U.S.). A taxpayer is "participating in
OVDP" if he or she submitted the OVDP Letter and Attachment by
July 1, 2014, and if the IRS and the taxpayer did not execute a
closing agreement before that date. A taxpayer who only requested
preclearance by July 1, 2014, but who had not by then submitted the
OVDP Letter and Attachment would have to "opt out" of
OVDP to take advantage of the Streamlined penalty structure;
however, such action is irrevocable and after opting out, a
taxpayer cannot later re-enter OVDP. Any taxpayer seeking this
transitional period treatment must execute the non-willfulness
certification required by the new Streamlined program, under
penalty of perjury. Importantly, for taxpayers seeking this
treatment, the other requirements of OVDP remain; the taxpayer must
still file amended returns and FBARs for the prior eight tax years
and pay all tax, penalties and interest otherwise required under
OVDP.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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